Wednesday, 11 June 2008

Dive into the Dow's (Cheap) Valuation

By Jeffrey Ptak, CFA, CPA

Is it time to buy?

We get this question a lot from subscribers. Some are trying to time the market--a strategy we frown upon. Others are simply looking for another opinion to add to their thought process, which is laudable.

Motives aside, we think the market looks undervalued, blue-chip names especially so. For that reason, we'd be enthusiastic buyers of ETFs that invest primarily in higher-quality, large-cap stocks, such as Diamonds Trust (AMEX:DIA - News), which tracks the Dow Jones Industrial Average. That fund was recently trading at a 19% discount to our estimate of the portfolio's aggregate fair value. Ordinarily, we'd be buyers of a portfolio like the Dow when it's trading at an 8% or greater discount to our fair value estimate. Thus, we think Diamonds Trust is a plum deal at these levels.

But what are we seeing in the Dow that the market isn't? And is it through rose-colored glasses?

Those questions loom larger given blue-chip stocks' influence on the valuation of many ETFs. Indeed, the Dow components pop up in a number of ETFs, reflecting the way market-cap weighting--which most funds employ--vaults the biggest firms into the upper rungs of many portfolios. (Better than one in 10 ETFs owned IBM (NYSE:IBM - News) shares as of April 30, 2008, for instance.) And with blue chips looking inexpensive, on balance, that largely explains why we're seeing a lot of undervalued ETFs these days.

With that in mind, we thought it would be useful to peer deeper into some of the key assumptions that underpin our fair value estimates for the 30 Dow components. The most important of those assumptions--our growth and profitability forecasts--essentially dictate the timing and magnitude of the cash flows we're expecting these businesses to generate in the future. Those cash flows, in turn, form the basis for each fair value estimate that we place on a business.

GrowthIf you thought that we were expecting the Dow components to take off in the coming years, think again. In fact, our growth assumptions are relatively sober on the whole.

Let's start with sales growth: In aggregate, our forecasts assume that the Dow components will increase revenue at a 5% compound annual growth rate from 2008 to 2011. When we decompose that figure by sector, the range is surprisingly narrow, bracketed by 8% at the high end (industrials) and -3% at the bottom (energy). Indeed, we're expecting most of the major economic sectors represented in the Dow to increase between 3% and 6% per annum, with financials (7.5%) and software ( Microsoft (NasdaqGS:MSFT - News), 7.5%, for example) being notable exceptions.

Where's the growth in industrials and financials coming from? We're expecting Boeing (NYSE:BA - News)(11% CAGR) and Caterpillar (NYSE:CAT - News) (9%) to pace growth among the industrial names. With respect to financials, generally speaking we're forecasting a widening of net interest margins (i.e, the profit a bank pockets when it borrows short and lends long) and also expect certain fee-based businesses to perk up. However, a big chunk of the growth is simply snap-back from a dreadful 2007 campaign.

As for individual names, we're forecasting double-digit annualized revenue growth for just two Dow components-- Citigroup (NYSE:C - News) (10% annualized) and Boeing (11%)--with a handful of others including American Express (NYSE:AXP - News) (9%), Intel (NasdaqGS:INTC - News) (9%), and Caterpillar (9%) touching high-single digits. At the opposite end of the spectrum one finds Chevron (NYSE:CVX - News), where we expect revenue to contract slightly, reflecting our belief that oil prices will gradually trend down in 2011.

Our operating income growth forecasts generally track the trajectory of sales, albeit at a slightly steeper angle in some cases. (Operating income, sometimes referred to as pretax income, is a firm's operating revenue less its operating costs.) The most conspicuous example is the financial sector, where we're forecasting 16% annualized operating income growth, or roughly double our top-line growth forecast. How can this be? As write-offs gradually decline, which we expect, operating margins (operating income as a percentage of revenue) should revert to levels that more closely approximate the historical norm. By contrast, we're forecasting a roughly 10% annualized operating income decline for energy names Chevron and ExxonMobil (NYSE:XOM - News). This is a function both of our revenue forecast (i.e., declining oil prices come 2011) and the degree of operating leverage in those businesses (i.e., scale is a blessing when sales are ramping higher, a curse when it's fading).

Our 7% forecasted earnings per share growth rate for the Dow more or less tracks the growth in operating income. A similar story holds for our 5% annualized free cash flow growth forecast (i.e., operating cash less capital expenditures; it's a reasonable proxy for the cash flows that form the basis for our fair value estimates) only slightly lags operating income growth. Cash flow can diverge from operating income for a number of reasons, not least of which is a firm's capital-intensiveness. By that standard, it's somewhat surprising that we're forecasting 16% annualized free cash flow growth for the Dow's industrial components, a tally that surpasses all other sectors, as industrials tend to be more, rather than less, capital-intensive. However, that's largely a function of one name--Boeing--where we're expecting cap-ex to gradually tail-off as a percentage of revenue, goosing free-cash flow generation in the process.

The upshot is that while we hardly expect these businesses to stand in place, our forecasts aren't predicated on lofty growth projections. In fact, we expect most of these businesses to churn out sales, profits, and cash flow in the mid-to-high single-digit range.

Click here to see the table. http://news.morningstar.com/articlenet/article.aspx?id=240665

ProfitabilityWe've already touched on some aspects of our profit outlook. After all, operating income, free cash flow, and earnings per share growth are all partly a function of a firm's profitability. But it's still helpful to examine our profit forecasts in gaining a sense of which firms and industries we expect to rake it in.

What do we find? You'd have to be blind to miss it--this is a very nicely profitable group of businesses. In aggregate, we're expecting the Dow components to notch a 19% average operating margin from 2008 to 2011, a haul that well exceeds the norm across our coverage universe. While that profit forecast might seem fanciful, these are firms that wield durable competitive advantages--ranging from intellectual property rights ( Merck (NYSE:MRK - News), 3M (NYSE:MMM - News)), impregnable scale ( Wal-Mart (NYSE:WMT - News), ExxonMobil), and iconic brands (Coca-Cola (NYSE:KO - News), Procter & Gamble (NYSE:PG - News))--to keep competitors at bay and consistently churn out profits. Moreover, while we're generally expecting the Dow components to see some operating margin expansion, we're not projecting dramatic changes. For instance, we're expecting Johnson & Johnson's operating margins to average roughly 26% from 2008 to 2011, which essentially matches the firm's operating profitability from 2003 to 2007.

Which are the most profitable industries and names of the lot? We expect Microsoft--the software sector's lone representative in the Dow--to mint profits to the tune of a nearly 40% average operating margin. We're also forecasting robust profitability anew in the health-care sector, where we expect Johnson & Johnson (NYSE:JNJ - News), Merck, and Pfizer (NYSE:PFE - News) to churn out about 31 cents in operating profit, on average, for every dollar of revenue they pull down. By contrast, we're only expecting a 13.8% average operating margin from the Dow's consumer-services names, which include Wal-Mart (6% average operating margin), McDonald's (NYSE:MCD - News) (25%), and Home Depot (NYSE:HD - News) (9%).

But cash is king, right? In that spirit, we've also taken a look at these businesses' free cash flow margins (essentially, free cash flows as a percentage of revenue). As one might expect, the free cash flow margins are a tad less eye-popping--we expect the Dow to churn out an 11.3% free cash flow margin, on average. But the overall profitability trends across sectors and names hold more-or-less constant, with less-capital intensive firms (software, health care) expected to generate plumper free cash flows than their counterparts in capital-heavy sectors like the oil patch, industrials, and consumer-related realms.

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